Credit Risk Memos (CRM's)
For Small Business Debt and Repayment
Credit Awareness Tools & Insights
CRM #4 – Appraisals, Evaluations
Certified or licensed professionals render their appraisal opinion as to fair market value of real property. Certain smaller transactions and renewals or refinancing do not require appraisals, and less formal Evaluations may be used in their stead. Appraisers use three valuation approaches: Cost approach, Sales Comparison approach, and the Income approach. The appraiser will reconcile the three approaches to value in order to arrive at the as-is market value of the property.
Cost Approach – Used to estimate the reproduction cost of the improvements less depreciation, plus the land value. Older properties make this approach more difficult to use, and is also not used in a troubled market as construction costs will exceed market value of existing properties.
Sales Comparison Approach – Uses selling prices of similar recently sold comparable properties in the local marketplace to estimate the value of the subject property. The approach is more suitable for similar owner-occupied single-family properties, and will add support for commercial properties.
Income Approach – Mostly weighted for income-producing commercial real estate. It is based on the discounted value (present value) of future net operating income, and should reflect the sales price of the subject property.
Appraisal are performed as either a Complete or Limited appraisal. Both assignments may be prepared in three formats – a Self-Contained report, a Summary report, or a Restricted report. The degree of detail separates the three report types; the Self-Contained report is the most comprehensive. A Complete appraisal must conform to the Uniform Standards of Professional Appraisal Practice (USPAP), and a Limited appraisal allows for certain departures of those standards under certain circumstances. The appraisal and evaluation process must be independent from the loan production function at institutions, and the person performing the appraisal certifies that he has no interest in the property. This process of independence also includes the appraisal engagement and selection of an appraiser.
If market conditions are distressed, and income properties are generating insufficient cash flow, it may be difficult to obtain sufficient financial information on comparable property sales. Financing may be difficult to obtain, and the marketplace may have numerous distressed properties for sale. The appraiser will have to use his best judgment in projecting future net operating income over time based on historical levels and trends, and current market data. As a debtor, you will have to stay clear of the appraisal function. Any appraisal you may engage, or appraiser you recommend for selection, will not be permitted or used in the appraisal process.
CRM #11 – Collateral
Real or personal property pledged as security as a secondary repayment source for a term loan; the collateral is subject to being forfeited should the loan go into default. A secured loan is a loan with collateral usually sufficient to repay some or all of the outstanding loan balance should the primary repayment source, cash flow, fail. The creditor may exercise his right to seize the collateral upon default. Generally, the type of collateral used will match up with the purpose of the loan.
Collateral is an important part of the underwriting process. Take real property for example. The value of the collateral will need to exceed the value of the loan amount, probably by 25% or so. There needs to be an equity cushion appropriate for the collateral type and the duration of the loan term. Creditors often will install a loan covenant that is designed to ensure the loan balance maintains a certain equity cushion throughout the life of the loan. Should the collateral value fall below a measured ‘loan-to-value’ ratio, the debtor may be required to reduce the principal balance to return to a compliant ratio. Regardless, the debtor’s loan documents will generally state that you are required to maintain the collateral in good condition while the loan balance is outstanding. Market values often increase but they often decrease too. The equity cushion will help ensure the creditor will be repaid if the collateral is the only repayment source for the loan.
Keep in mind that there’s a big difference between you, the debtor, owning the asset, and the creditor owning the asset. You will do what you will do with the collateral, but if the creditor forecloses or otherwise acquires the collateral it’s another story altogether. A creditor, usually a financial institution, will need to sale the collateral that is not part of the creditor’s business model. Lending institutions lend money; they don’t operate construction equipment, or office/warehouse buildings. The marketplace instinctively understands the difference, and when a creditor owns collateral that it desires to sell (has to sell), the creditor may encounter a steep discount, and possibly material expenses relating to the disposition of the collateral. It’s possible that discounts, based on collective bids or offers from the marketplace, may be 10 to 20 percent lower than what the collateral is worth. And, add that discount on top of depressed prices in the market, and you begin to see the value of the collateral from the creditor’s perspective.
Personal property, consisting of inventory, equipment, unlike real property, the creditor will perfect a lien interest in by filing a recorded UCC financing statement and you’ll also sign a Security Agreement. Rolling stock like vehicles, will be titled and the creditor’s lien interest will be recorded on the titles. Creditors will pull new UCC searches to confirm whether or not other creditors have a lien interest in the collateral, but the most senior lien position will be the first to be paid from the liquidation proceeds.
Now, before you and your creditor even think about talking about a cooperative or forced liquidation of the collateral, NCARA asks that you keep a few things in mind. This is your business; it’s serious business when you’re experiencing financial setbacks. If you don’t know already, you may know all too soon, the stress of insufficient cash flow, and the toll it takes on you and your family, employees, and other stakeholders. It’s a big deal. So, if your debt load is too heavy for you and your business, realize that it is possible that you may lose your business and all the equity you put into it. Yes, you can and should do everything you can to maintain your business, but give yourself some time to really think about the real cost of going too far to save the business. Why in the world would this make any sense?
Frankly, here’s the reason. Come along on a little journey a few years from now; put yourself in the shoes of a business owner that took his business way ‘too far’ in trying to save it. There are way too many small business owner’s tax returns filed each year that have alimony and child support. Behind the scenes of some of those businesses sits an owner by himself, with a half defunct business, where the fun of operating such a business is long gone. Many are the reasons why this is so.
In most cases, the personal failures should not have happened. Maybe the owner gave away too much time and resources to save the collateral: metal, sheetrock, wood, nails, screws, paint, rubber, plastic, tile, asphalt, cement, inventory, shingles, carpet, glass, and the list goes on and on and on. Ask yourself if such collateral stuff is worth it. In the meantime, he lost relationships with his wife, his children, his future grandchildren, and so forth. NCARA strongly believes that no business is worth that cost, whatsoever. A new business, under different circumstances can be formed at a later time. There may come a time to hand over the keys to the creditor and tell him you are taking your wife out to dinner. Think about it. Where do you sit today?
CRM #13 – Covenants: Financial, Performance, Reporting
Loan covenants are conditions that a borrower must comply with as specified in a Loan Agreement. Covenants involve reporting requirements, financial performance, affirmative and negative actions. If a debtor fails to adhere to the covenant requirements, it will result in there being a violation, and a technical default on the subject loan, enabling the creditor to call a ‘time out’. Its purpose is to enable the creditor a way to mitigate the increasing credit risk. It is common for creditors to formally waive covenant violations for a variety of reasons, which will not affect the remaining terms and conditions of the loan.
Creditors usually install the appropriate covenants (i.e., the number of covenants, and how often they are to be measured) as part of a solid loan structure. They just want to get repaid, and are not out to sabotage a debtor; else why would they lend the money in the first place? And besides, debtors agree with the terms in the Loan Agreement, or they at least sign the document whether or not they understand what they’re signing. Few probably take the time to read and understand it. That said, covenants protect the creditor’s interests by requiring the debtor to achieve certain performance financial ratios or benchmarks, and also to submit financial reporting on a regular basis (i.e., monthly, quarterly, annually). See NCARA credit risk memo entitled: Ratios, Financial.
Loan covenants serve various purposes. Performance ratios may involve metrics for profitability, efficiency, leverage, and liquidity. The creditor is seeking to preserve asset quality (i.e., cash, accounts receivable and inventory), maintain cash flow and net worth, and control growth. Other purposes include ensuring proper financial disclosure, and making sure management quality is maintained. Covenants will also protect the creditor by ensuring the business continues to operate.
There are also affirmative covenants which require the debtor to ‘do’ certain things. For example, they may include: paying all payments when due, maintaining insurance, paying taxes, providing financial reporting, meeting minimum or maximum financial ratios, maintaining certain levels of working capital and net worth, following certain accounting procedures, permitting inspections, advising on litigation, and maintaining fixed assets.
On the other hand, negative covenants will limit and prohibit the debtor from doing certain things. For example, the covenants may limit: new debt, sale of assets, capital expenditures, lease payments, officer salaries, and dividends. Covenants can prohibit certain types of investments, loans to certain parties, mergers and acquisitions, and change in management. For longer-term loans, all loan covenants will be fully described in a formal Loan Agreement and are binding. Alternatively, where there is no Loan Agreement it may be more likely the loan has a short-term maturity with a balloon payment; this will allow management to take an appropriate review at maturity, which is pretty much what covenants do in long-term loans.
Creditors are expected to prepare appropriate covenants so as to not have them too tight or too liberal (too much ‘headroom’) before they trigger a default. If they are too restrictive, it will be more likely that the company will frequently trigger unwarranted violations. At the other extreme, if they are too trivial with too much headroom, the borrower might be insolvent before a financial covenant is triggered, which does nobody any good either. Again, covenant violations are serious and can result in the acceleration of the debt’s maturity date.
As a debtor, you need to read and understand what your loan covenants are: performance, reporting, affirmative, and negative. It’s doubtful most debtors ever read them all, but if you’re in an economic downturn environment, they become increasingly more important. Covenant limits are more likely to be triggered, and the ‘fine print’ in the Loan Agreement could come back to bite you if you’re not prepared.
As noted earlier, covenant violations are serious business, and it’s entirely possible that if not corrected, the creditor could demand payment in full – in 10 days. The ‘gloves could come off’ and you may not have a clue what’s happening before it’s too late. So, pull out the Loan Agreement and read it and research it until you understand what it’s saying. If you don’t have a copy, ask for a new copy from the creditor. It’s okay to ask the creditor what the loan covenants mean, how they’re calculated, and so on – if you need to. Not everyone is conversant with such covenants. No question is a dumb question. After all, if you have loans outstanding, you’re already ‘in bed’ with the creditor so you may as well get it figured out.
Assuming you are compliant with the reporting requirements (i.e., you submit all your financial statements, certifications, etc., on time), focus your attention on the ratio requirements in the performance covenants. As poor economic conditions play out, it’s likely that you will trigger a violation for not performing as agreed. Does that mean the covenants themselves need to be adjusted higher or lower so as not trigger more violations? Maybe. But perhaps the covenants metrics are appropriate; you need to perform to those certain expectations in the near term. If that’s the case, it’s likely the creditor will recognize the violations when they happen, but will issue a waiver letter each time a violation happens. If the covenants become unreasonable, then maybe it’s time to have them adjusted so violations don’t happen.
Creditors need to be realistic and recognize that your financial condition has, in fact, deteriorated, and that will affect your covenants accordingly. So, for you, it is important to actually understand the covenants, what they are, what they mean, and how they’re measured. It tells you how much ‘room’ you have to operate before a violation is triggered. You need to speak up if they are too restrictive. You have a say in the negotiations. It is your business. How can you possibly sign a Loan Agreement and essentially enter into ‘covenants’ if you don’t agree with them, or understand them, in the first place?
Remember, creditors didn’t have to lend you the money in the first place, or when there’s a covenant violation. But that doesn’t mean you shouldn’t have a clear understanding of what they are, and have a voice in how covenants are structured in the Loan Agreement each time you sign one.
CRM #16 – Environmental Risk
Lenders face potential environmental liability with the real estate they hold as collateral if they were to foreclose and take ownership – even if the creditor was not originally responsible for causing the contamination. Creditors would need to prove they are innocent landowners if they foreclosed on real property contaminated with hazardous waste. Many businesses produce waste as part of their operations, be it technology firms, service stations, waste disposal companies, machine shops, and other manufacturers; some waste, however, may be hazardous which requires special handling and disposal. If those processes are not done correctly, for whatever reason, environmental risk will increase not only to the debtor, but potentially to the creditor. If the creditor determines there is too much environmental risk on a property, it may decide to not foreclose after all. Perhaps a financial institution may acquire, via a merger or acquisition a loan with contaminated real property. They do not want to become liable for any cleanup costs for hazardous substance contamination that may have occurred on the collateral property.
Beginning with the environmental underwriting due diligence process at origination, the creditor is going to determine its degree of environmental risk. The debtor will be required to confirm via certain environmental disclosures, that environmental due diligence was completed at the time of acquisition. The measures will also likely include due diligence on the prior owners and operators of the subject property. These disclosures will help protect the creditor as well as the purchasing debtor. This due diligence will put the debtor and the creditor in a position of being an ‘innocent landowner’, and therefore not responsible for environmental clean-up. It also affirms that the creditor acted prudently should it ever have to foreclose on the real estate.
More specifically, this due diligence process is normally accomplished by an onsite inspection, the debtor’s completion of environmental questionnaires, online government record searches, and if necessary, cause to be performed certain environmental audit testing by trained professionals:
Phase One Testing – Site visit, historical records, regulatory review, geological and hydro-geologic review, summary report
Phase Two Testing – Investigation on Phase One findings, physical sampling of subsurface soils and ground water
Phase Three Testing – An approved remedial action of contaminated area, subject to regulatory and licensed oversight
Knowing the environmental risk upfront, and later on if necessary, protects the creditor because environmental contamination on the collateral property can have an adverse impact on its value. The debtor may not have the resources to remediate the contamination as well. If that were to happen, it would further aggravate the prospects of repayment from both the primary and secondary sources, as clean-up costs can ultimately be cost prohibitive for all stakeholders.
Examples of environmental hazards include contamination and toxic substances from chemicals and waste products, fuels, cleaning solvents, leaking underground storage tanks, building materials, asbestos, etc. These substances can travel underground to neighboring properties and increase the potential costs of cleanup. Again, if the original repayment source ceases because the company’s operation fails, the creditor may be left with contaminated collateral as its only repayment source, and the value of the property may be substantially impaired.
Once the loan is disbursed, the creditor may act as if he already owns the property, as it may have to turn to the collateral as its ultimate repayment source. If the collateral property is contaminated, depending on the severity, it’s entirely possible that the creditor could abandon its right to the collateral (i.e., not pursue liquidation of the collateral, or foreclosure). If a lender acquired the property, and it ended up being contaminated, the creditor may be held liable for the environmental cleanup of the property; the cost could end up being much more than the amount of the loan secured by the property. Creditors pretty much know how to ensure they understand the environmental risk and take the necessary precautions to avoid unwarranted risks.
You should also understand environmental risk too. Why would you not want or need to know everything about the potential environmental risk on the property you propose to purchase, or on an existing property you already own, just like your creditor needs to know? Think about it. You too could bear such liability for the environmental cleanup costs, and that expense may threaten the solvency of you and your business as well.
CRM #21 – Guarantors
Loans are underwritten based on the primary repayment (cash flow), and secondary repayment (collateral) sources, and a tertiary source may be the financial strength of any guarantor(s). Loans are not to be made based only on the strength of the guarantor. Guarantors, or interested/benefited third parties, are often included in the loan structure in order to help repay the loan should the debtor default on the payments. This includes guarantees for general partners, 20% plus owners of a closely held corporation, owners of a startup company, or on U.S. Small Business Administration (SBA) loans.
When guarantees are in place it’s considered that there’s ‘recourse’ to the principles; they unconditionally guarantee repayment of the loan. If there are no guarantors to the credit, which has become common in the past few years (probably due to increased competition and lax underwriting standards), then the loan would be ‘non-recourse’. In most cases, where there is a guarantee in place, the amount of the guarantee will be unconditionally 100% of the full balance, a joint and several obligation; every individual or legal entity that signs the guarantee is fully responsible for 100% of the loan amount, not just a certain percentage of the loan amount. Other guarantees may have limited recourse to the guarantor.
An owner/guarantor will realize that should the business fail, the creditor will come looking for full repayment. If a guarantee is executed, the owner/shareholder of the corporate borrower will be fully liable for debt repayment, and will know of a certain philosophical commitment. In order for the guaranty to be legally enforceable, and worth anything to the creditor, the guarantee will need to be a properly written and signed, and ‘consideration’ given to the guarantor. An actual guarantee is a very complex and detailed document and ensures that the guarantor must repay the loan if necessary. Creditors will be sensitive to those assets owned in and subject to the rights allowed in a community-property state, or in a trust. If they want such-and-such assets to be part of the guarantee, they will ensure the documentation includes the appropriate language and signatures.
Creditors will look to you, the guarantor, for financial support particularly when and if the loan becomes a ‘problem or classified’ loan – when there’s difficulties with the repayment sources. You can expect to see a concerted effort to obtain current detailed financial information from you and any other guarantors, and determine your ability to provide adequate cash flow support. This includes information about your income, assets, liquidity, and contingent liabilities. These measures, however, are only going to document your ability to repay. On the other hand, in order to get any real repayment support, the creditors will assess your ‘willingness’ to repay. There has to be both: ability and willingness to repay. Willingness is manifested by performance, actually making payment when required or asked to do so. It’s not just saying: “Sure, I’m happy to pay”, it’s actual payment; that, is demonstrated ability and willingness.
But let’s step back and imagine for a moment, earlier in time about a loan that ultimately went into default. Have you ever heard of ‘guarantor fatigue’? When you guarantee a loan that has a troubled primary repayment source, cash flow, and it is either insufficient or heading that way, the creditor is going to come ‘knocking on your door’. At that early stage, you will probably be doing all you can to support repayment of what you hope and expect will be a short-term period of difficulty. So, for several months or quarters, you provide back-up support in supplementing cash flow deficiencies in order to keep the loan current. You’ve demonstrated both an ability and a willingness to honor your guarantee. Maybe you burn through your liquidity on hand, and then start to draw down on other lines of credit to come up with the necessary cash each month. Are starting to get tired yet? Now suppose that you, as well as the creditor, realize that you have a personal financial statement that shows a considerable net worth, right? Do you see where this is going?
Fast forward a year, and the business isn’t able to keep up the payments and solve the reasons for there being insufficient cash flow. It doesn’t look good. Let’s focus on what you are going to do now. You clearly have a solid case of ‘guarantor fatigue’ at this stage; you’ve burned through your liquidity, all sources, and now it’s getting painful; you’ve been carrying the loan for a year and you’re getting worn out. To stand behind the loan you promised to pay as a last resort, you’d have to ‘cut into the bone’, and it would hurt greatly, financially.
You have a choice. NCARA believes you need to be honest and stand up to your guarantee at whatever financial cost it requires. Do yourself a favor and read each and every word of the guarantee you signed before you make the choice as to whether or not you will honor it. After reading it, what would you choose to do? Sadly, and probably in most cases, the guarantor is going to do anything and everything he can to avoid making arrangements to pay the remaining loan balance, even after the collateral assets have been liquidated. These guarantors would even spend ‘good money’ to hire an attorney, and look to make every excuse to ‘wiggle off the hook’. Is that what you’d do too?
Or, would you do the right thing and honor your guarantee? An honest person, a guarantor who was obligated to repay an unpaid debt, would approach his creditor with a fully prepared current personal financial statement with supporting documents, and sit down and work out an arrangement whereby certain assets could be sold and the proceeds be applied towards the unpaid balance until paid in full. What if doing so meant that it would ‘cut to the bone’, and there was real loss of assets and financial pain? Well, that’s precisely what you gave your unconditional promise to do if the business loan went unpaid.
NCARA firmly believes guarantors need to be honest to the core and fully stand behind the obligations they promised to repay. Don’t sign a personal unconditional and unlimited guarantee unless you’re prepared to fully pay up with everything that’s on your personal financial statement at origination, and now.
CRM #24 – Insurance: Title, Hazard, Flood, General Liability
To protect the creditor’s interests (i.e., the loan commitment amount), the debtor will be required to have and maintain adequate and appropriate insurance coverage at all times.
Title insurance – For real estate financing, this insurance will be required to verify and protect the creditor’s intended lien position on the property. Most creditors will structure the loan to be in a first lien interest, and will require that position be insured via an ALTA Lender’s title insurance policy. Such a policy is designed to protect the creditor against possible claims or other issues on the title to the real property, namely: correct ownership vesting, title defects, lien priority, unrecorded mechanic liens, assessments, encumbrances, encroachments, easements, water rights, mining claims, patent reservations, and conflicts of boundary lines. The policy is designed to insure the creditor against any loss for the entire length of the loan. Prior to booking the loan, the creditor will receive a Commitment for title insurance showing the status of the property so the creditor’s documentation and interest will be properly prepared for recording.
Hazard Insurance – Insurance that covers property damage caused by fire, wind, severe storms, hail/sleet, and other natural events – to the extent those things are covered in the policy. Creditors will require an annual policy premium to be paid or in place at all times; the creditor will be listed as the loss-payee in the event of a claim.
Flood insurance – Where applicable (i.e., the real property is located in a ‘flood zone’), flood insurance is required on all loans that are secured by real property. The creditor has procedures in place to verify whether or not the subject property is a flood zone (per flood zone maps) and requires flood insurance, or not. If so, the debtor will promptly be notified, as the loan won’t be closed without flood insurance.
General Liability Insurance – The creditor will be named as an additional-payee for this insurance coverage, in order to be protected from a variety of various lawsuits and similar claims. Such claims may include bodily injury, property damage, personal injury and others that can arise from the debtor’s business operations that involve visiting customers or vendors. Builders risk insurance coverage will also be required for in-the-course-of-construction building and renovation projects. This insurance indemnifies against damage from physical loss or to buildings while under construction.
In a distressed problem loan scenario, the creditor is going to do a credit file review to determine the status of its collateral; insurance coverage is part of that review. The creditor is expecting there to be an original title insurance policy with its endorsements. This confirms his insured interests as a creditor in the real property at the time the loan was originated. Now, however, a new updated title report will be necessary to ensure who the current vested owner is, and whether or not there is any newly recorded exceptions or liens against the property. The creditor needs to ensure his lien interests are what they were expected to be. Unpaid taxes and mechanics liens may pose a challenge to the creditor’s interests, and will have to be researched and addressed.
It is possible that you may not have the funds to maintain adequate hazard or flood insurance coverage. It happens. Creditors, however, by virtue of your signed loan documents, may find and apply some type of forced-placed insurance coverage, and add the premium costs to your loan balance. You may or may not be in a position to care about it, depending on your financial condition – you should always care about it. If you are able to repay over the long-term, know that it will be very expensive to you. If you will not be able to hold on to the collateral property, it will likely be part of an unpaid deficiency balance that you may be responsible for.
NCARA believes debtors need to honor the terms and conditions of their loan documents. In those times where it’s not possible to service the debt, and maintain operations, the debtors should keep appropriate insurance coverage in place at all times. If you have to make adjustments to lower the net available cash flow to service debt, then so be it. With detailed financial statements, and a well-prepared pro forma cash flow statement, the insurance costs can be identified and reconciled with the remaining cash flow to service debt; the creditor will realize that the insurance coverage will be paid for under the ordinary course of business, and there will likely be less available for debt service. It is expected that corrective actions will be taken to improve the cash flow to normal and improved levels over time. Meanwhile, the insurance policies designed to protect the interests of all parties remain viable and in place.