Credit Risk Memos (CRM's)
For Small Business Debt and Repayment
Credit Awareness Tools & Insights
CRM #26 – Loan Types
Agricultural (Ag) Loans
Ag loans finance the production of livestock, crops, fruits and vegetables. They also are used to finance the farmland, machinery and equipment for its operations, and other improvements to the operations. Short-term loan types include production loans (seed to harvest and sale); they fund feeder livestock loans to purchase cattle, hogs, poultry, sheep, livestock until they are mature, slaughtered, and sold. Intermediate term loans include breeder stock loans to fund purchases of beef and dairy cows, sheep and poultry, and repayment based on the offspring of the stock animals or their milk or egg production. Long-term loans are made to acquire the farm real estate and the permanent improvements for its operations.
Ag lending faces material risks that may result in need for material modifications to effectuate repayment. These risks include the prices for commodities (i.e., dairy or beef prices), and weather conditions (too wet to plant or harvest, or drought). These risks can happen and there’s little that can be done to stop it. Prudent restructurings will be necessary and should not be criticized by regulators. Carryover loans are made to satisfy short-terms loans that cannot be repaid as agreed, and are expected to be amortized over an intermediate period. Depending on the available collateral and the borrower’s overall debt service capacity at the time, the ability to repay may be jeopardized. Workout plans are established to not only help the borrower, but to minimize loss to the creditor.
In a workout situation, a creditor is going to seek to enhance its collection position by trying to get additional collateral, new cosigners, guarantors, government guarantees, change the interest rate or payments, advancing new monies, or even having assets sold to reduce the outstanding debts. It’s possible outstanding debts can be refinanced at another institution or a creditor will have to recognize there’s loss in the relationship and a partial charge-off may be necessary.
Asset-Based Loans - Accounts Receivable (A/R), Inventory
Asset-based lending is generally used to fund rapid growth, fund working capital needs, and take advantage of purchase discounts. The primary repayment source is the conversion of the pledged assets to cash, however, the lender expects the debtor’s business to be performing well, as collateral liquidation is the last resort. Receivables and inventory are generally pledged as collateral (“blanket lien”), to protect the creditor’s interest with predetermined collateral criteria outlined in a borrowing base. Creditors can get a higher-yield loan as to the perceived credit risk of the borrower, and generally includes a depository relationship too.
A/R financing is a specialized revolving line of credit, and structured such to represent the credit risk (repayment ability) of the cash flows. Financial reporting is paramount and includes borrowing base certification (BBC) of compliance, with operating and cash flow statements. The BBC is a detailed analysis of the accounts receivable and inventory to ensure there are sufficient quality assets to protect the outstanding balance and any advance requests. In other words, the line of credit balance fluctuates depending on the amount of available assets that secure the loan at any given time. Depending on the risk profile, a BBC may be required quarterly, monthly, weekly, or even daily. If a line of credit, having a BBC, is determined to be over-advanced, a principal payment will be required to return the outstanding line balance back to a conforming basis based on the eligible collateral. The creditor will also focus on the trends of working capital, and carefully analyze the turnover ratios of the accounts receivable and payable, as well as the inventory turnover ratios.
Creditors will likely be able to recognize deteriorating financial performance, and are prepared to begin liquidation of the collateral assets, if necessary. If future advances cease, the collection of accounts receivable, and the sale of the inventory will be used to repay the subject loan. Obviously, such actions will result in the business likely going out of business or filing a bankruptcy petition. When a debtor is in serious financial condition, it is possible the accounts receivable debtors will react with their own disputes, and collection in full may become more impaired. Before these measures take place, however, the creditor will have likely taken steps to remediate any problems before liquidation becomes necessary.
Creditors will be closely monitoring the ‘excess availability’ in the credit line, as the more margin the better the chance of servicing the loan. The accounts receivable and inventory can generate only so much available borrowing on the line, and those trends will indicate the assigned rating and level of monitoring necessary to protect the creditor’s interests or position. Financial performance covenants may be installed, which if violated, may result in a condition of default, and trigger remediation measures. The covenant structure will likely be made based on an initial credit analyses based using projections. These projections will show the availability under the line at the creditor’s loan policy advance rates, in order to satisfy working capital needs.
Creditors will also regularly review, or require an independent audit of the accounts receivable and inventory to ensure their authenticity and collectability. The audit scope will include verification that the information on the BBCs is reconciled to the debtor’s financial recordkeeping, and many other controls. Some of the standard criteria for determining acceptable collateral for the BBC include eligible accounts receivables that carry an acceptable degree of credit risk. Ineligible receivables may include delinquent accounts over 60 days past the invoice date with 30 days repayment terms, or 90 days past invoice date; government receivables (not assignable), foreign account debtors, retention amounts, contra accounts where the borrower sells to and purchases from the account debtor; affiliate accounts where sales are made to an affiliate company (i.e., common ownership); and concentration accounts where a large percentage of the receivables is sold to one, or to just a few accounts. Inventory advance rates on finished inventory will also be determined, typically from zero percent to as high as 50 percent or more, with an eye on its liquidation value. Audits of the inventory will confirm the degree of obsolescence (i.e., no longer in demand), seasonal goods, oversupply, or raw materials and finished goods that are difficult to get rid of.
Creditors and debtors want the line to function as per the Asset-Based Loan Agreement, else the financing may not be in place in order for the business to continue its operations. Should a loan covenant be violated, the creditor has the option to waive the violation or give the borrower more time to take appropriate action to cure the default. Creditors will likely inform the debtor in writing as to any violations, and failure to do so, and if the line is canceled without proper notice, the creditor be may inconsistent in its actions and potentially become subject to lender-liability.
For the lending relationship to be successful, the creditor will likely require monthly detailed account receivable aging reports to determine eligible receivables, and possibly a lockbox arrangement in order to control the collection and receipt of the receivables to the creditor. If the receivables turnover slows down it could mean there’s a deterioration in the quality of the accounts. Debtors will likely know the financial condition of account debtors through their own underwriting criteria to help ensure collectability and quality.
Commercial and Industrial Loans (C&I)
Commercial and industrial loans are made to legal entities may be the most significant assets of a financial institution. They are often secured or unsecured and their maturities may be short or long term. They are not real estate or consumer installment loans, and their purposes cover a wide range of borrowing needs, including a business’ short-term working capital (i.e., seasonal) needs to finance accounts receivable and inventory, manufacturing, retailing, etc. Term loans are granted to finance capital assets or equipment, and the assets are typically taken as collateral.
Commercial Real Estate (CRE) – Owner Occupied (CRE-OO), Non-Owner Occupied (CRE-NOO)
CRE financing is generally considered to be permanent financing generally for the purchase of the real property. This could mean a 30-year mortgage loan to finance a commercial building, the term could be a 10-year loan with a 20 to 30-year amortization, with a balloon payment due at maturity in 10 years. The interest rate may be variable or fixed, and possibly fixed but adjusted every five years. The primary repayment source will be the borrower’s ability to repay (i.e., cash flow), and the secondary source of repayment will be the value of the underlying real estate collateral. If the real estate is owner occupied, the cash flow will come from the operating income of the owner’s business onsite. If it is non-owner occupied, the tenant rental income will serve as the primary repayment source. The loan structure will specifically limit the advance rate (i.e., 75% loan-to-value) to protect the creditor’s interest.
CRE loans may comprise a major portion of the institution’s loan portfolio in terms of dollar amount. One concern is whether real estate values have decreased from the original appraised value. Markets can become overbuilt or experience adverse economic conditions. Creditors are also going to pay close attention to the number of building permits being issued for new construction, absorption rates, employment trends, vacancy rates, cost and valuation trends in determining their appetite for CRE lending. Markets are sensitive and projects must make economic sense. Headaches can be caused by construction delays, rent concessions, slow sales of built out units, cost overruns, etc. Another concern may be were a creditor lends against an ill-conceived CRE project with a high loan-to-value (LTV) ratio.
Construction Loans: Residential, Commercial
Construction loans are short-term, and used to construct a project with specific time and cost constraints. The primary repayment source will be permanent financing, whether or not it’s being provided by the construction lender. The lender will also underwrite not only the subject project, but the contractor too; essentially all parties to the project will be subjected to verifying their expertise, financial condition, as well as their character and reputation in the marketplace. A wide range of projects are traditionally financed including office buildings, condos, apartments, shopping centers, and hotels. The project will be underwritten to be successfully managed, constructed, marketed, and include a feasibility study and appraisal. The study will analyze the supply-and-demand factors that will affect the project’s absorption rate. The subject property serves as collateral, in a first lien position.
A construction loan budget will itemize each of the direct/hard and indirect/soft costs, interest and contingency reserves, for the proposed improvements. The interest reserve will be used to cover interest payments during the construction period and until the construction loan is repaid, project is sold, or reached stabilization. A contingency reserve will be a reserve to cover unforeseen costs. A contract for the improvements will be executed between the debtor and his General Contractor, which shows the start and completion dates, construction draw request schedule, third-party inspections, payment terms, and lien waivers for each draw request. The stakeholders execute a construction Loan Agreement and other documents to control the project, such as recorded Deed of Trust, title insurance, property survey, environmental impact, takeout commitment, completion or performance bond, etc. It must be finished according to the construction plans, on time, on budget, with sufficient time for the permanent take-out financing.
Residential construction loans are made on a speculative basis, or for a specific buyer with a permanent take-out financing commitment. Construction loan administration will involve loan disbursement (i.e., progress payments), construction draw requests, inspections, inventory lists, lot release schedule, and interest reserves for interest-only payments.
Think ‘on time, and on budget’. If it goes that way, fine. If it doesn’t, there’s going to be trouble. Only when the project is finished will the real estate become marketable; until then, the value is questionable. Strict controls for disbursements (payment) and collateral margins can be expected. Should default occur, the creditor will likely be in position to complete the project, and have to deal with mechanic and materialmen liens, unpaid property taxes and possibly other judgments.
Installment loans, made to consumers for auto purchases, household appliances, home improvements, debt consolidation, are generally smaller loans with fixed or variable interest rates, and amortized for one to five years. These loans may be secured or unsecured. Such retail lending may result in there being an installment loan portfolio consisting of a large number of small loans, or even loans purchased from retail merchants, and will require a loan application, credit check, and possibly collateral. Indirect installment loans are known as dealer loans or dealer paper (i.e., purchased indirectly from a car dealer). Such loans are either purchased with or without recourse to the dealer should the borrower default.
Underwriting considerations may include a maximum debt-to-income ratio, of say, 40% of a debtor’s gross income for monthly recurring debt service. If a debtor needs a co-signer or co-maker to make the deal work, the loan becomes less attractive to the creditor. Usually there’s a minimum personal credit score that is required, say 700 or so. Debtors usually need to have at least a couple of years on the job to qualify to help ensure the reliability of verified and sustained income. It helps to have lived in the community over the long-term, and have limited unsecured borrowings. Certain consumer laws are also in place to help ensure fair lending and non-discrimination.
Home equity loans are typically junior lien secured loans whose credit limit is capped by the amount of equity the borrower has in its residence. The structure may be that of a closed-end second mortgage, fully disbursed at closing, and repaid over many years. It may also be structured as an open-end revolving line of credit. The interest rate is generally variable and the terms can be flexible (i.e., interest only or revolving feature for several years, followed by an amortization repayment period). Traditionally, such loans were extended for the purpose of making home improvements without a revolving feature. The proceeds of such loans are now for nearly any purpose. Extended repayment terms and liberal loan structures can increase the risk of default. Changes happen that can jeopardize the prospect of repayment, including a depressed economic environment, a spike in interest rates, a loss of a job or a change in marital status. The initial underwriting may be that the combined first and second liens don’t exceed 75% of the appraised value, serving as an equity cushion to protect the creditor’s interests. A minimum threshold will also be set on debt service coverage, and the debtor’s debt to income ratio in order to qualify.
As credit risk increases, the creditor may be willing to offer extensions, renewals, and workout modifications. Debts not collected will be charged off once the collateral has been liquidated. If foreclosure were necessary, the junior lienholder would be responsible to payout or debt service the senior lienholder, which would increase the junior creditor’s exposure. If there was insufficient equity, the junior loan would be in jeopardy of being foreclosed out of the picture.
Credit cards are used in lieu of cash for sales or services rendered. Amounts repaid in full each month generally don’t incur a service charge, and unpaid balances are repaid with monthly payments with service charges. Cash advances are also available. Credit lines are supposed to be carefully managed and match the repayment capacity of borrowers using proven credit criteria. Creditors should carefully control ‘authorizations’ to ensure over-limit practices are properly managed. Minimum payments are offered as creditors seek to have debtors maintain outstanding balances. If payments are not paid timely, it’s possible said payments will be insufficient to cover the finance charges. Debtors are expected to make payments sufficient to amortize the balances over a reasonable period of time. Workout plans will likely require full repayment within five years.
Desirable, Undesirable, Prohibited Loans
Often, depending on economic conditions (i.e., recessionary vs. expansionary), creditors will be prescriptive in outlining the types of deals that they want to grant, or prohibit. Creditors seek to lend in a safe and sound manner, not discriminate, and make prudent lending decisions on loan requests in their target or service marketplace. Desirable loans may include loans that are appropriately secured with collateral in a senior or first lien position. Some creditors seek real estate secured loans and others do not. Marketable securities are also used to secure loans, and even cash-secured loans. New vehicles loans are desirable, as well as home equity lines of credit. Asset-based lending and other short-term loans are also desirable.
Loans that are undesirable may include loans to start-up companies, and those with collateral that is older, and not readily marketable. If the primary source of repayment is the sale of the collateral, such loans are also discouraged. Creditors have been known to lend on the basis of the strength of the guarantor, as opposed to the business, but those loans are also generally less desirable. Creditors may also want to have lending relationships that include depository accounts and may avoid ‘transactional’ only borrowings, loans that will be expensive to service, and those where the creditor can’t reach certain yield requirements. Other loans less desirable would be those secured by a junior lien position, or where the debtor has a partial ownership in the collateral.
It may be obvious, but some creditors will not lend money under certain conditions. Character is usually atop the list, and if a client is deemed to be dishonest or lacks sufficient integrity, the lending decision will likely be negative. Spec lending on stocks is not generally acceptable, or are loans secured by restricted stocks. The creditor may have a certain size limit due to capital constraints and therefore lending limits will apply. Clients that are in bankruptcy or have recently been in bankruptcy may also not be granted credit. It should go without saying, but loans for illegal purposes or transactions, will likely be prohibited. Predatory lending is also likely to be prohibited.
The general purpose of term loan financing is for the acquisition of long-term assets, with longer-term maturities of more than one year, with a fixed or variable interest rate. Term loans can be used to amortize the balance of unpaid revolving lines of credit too. Cash flow over multiple operating cycles is the generally the primary repayment source. Collateral, the secondary repayment source, is often required due to the long-term maturity; interest is generally paid monthly or quarterly. The term of the loan will be less than the remaining useful life of the collateral. The loan structure will likely include certain loan covenants, measured regularly, and require the borrower to meet certain financial performance thresholds and financial reporting expectations.
Land Acquisition and Development Loans
These loans are generally made to investors and speculators, and are used to acquire the land for development (i.e., land preparation, utilities, road construction, building lots), for eventual construction, or to sell the property at a future time. Land development financing will include a development plan with cost budgets, legal expenses for permits, environmental studies, utilities installation, etc. The LTV will be such as to provide an adequate margin to account for unplanned expenses and protect the creditor. The value of the land will be based on its highest and best use, and on an ‘as-is’ basis, and possibly the ‘as completed’ basis. Repayment structure may follow the development and sale of the land. Normally, additional sources of repayment will be required due to the speculative nature of the transaction.
Letters of Credit
A letter of credit is provided by a financial institution acting as an intermediary, and used to facilitate a transaction between a buyer and seller of goods. It is used to facilitate the payment of those goods. Such letters of credit are often used for international trade as there are different legal and banking systems, etc. Essentially, a financial institution is committing to pay, typically on an irrevocable basis, for the goods on behalf of its customer, which gives the seller comfort that it will be paid for delivering the goods. Generally, the buyer and seller of goods are not that familiar with each other. The buyer’s financial institution will be used to guarantee payment to the seller once there is appropriate documentation showing the goods have been shipped and title has transferred. The buyer’s financial institution is then required to make payment to the seller, and the institution is reimbursed by the institution’s ‘buyer’ customer together with a fee.
Lines of Credit; Working Capital Loans
Working capital loans provide liquidity for seasonal operations on a short-term basis, and finance the business’ operating cycle. This starts with the acquisition of raw materials, the creation of products, sale of the inventory and the collection of any accounts receivable. Businesses will use these lines of credit when their operations are seasonal or there are peaks in current assets or current liabilities such as the holiday season, or manufacturing closing over a particular season. Lines of credit are structured on a revolving basis, mature, and subject to renewal each year.
Interest payments are generally due monthly or quarterly, with any unpaid interest and principal due at maturity. A ‘cleanup’ period to bring the balance to a zero balance at the low end of the operating cycle for a period of time (i.e., 30 days) is often required. Resting the line of credit, unless the business is in a material growth phase, helps ensure the borrower is not dependent on the lender for permanent financing. Loan advances may have certain restrictions and repayment is usually based on the conversion of current assets (inventory, accounts receivable). Hence, the repayment source is closely tied to the borrowing cause or purpose.
Working capital lines of credit can be misused too. Businesses that are experiencing losses may use the line of credit to finance operating expenses, debt service or other costs, and not use the line for its intended purposes. Another misuse would be to use the line to finance long-term assets, like equipment. A term loan facility is to be used for long-term assets. Trade creditors, or accounts payable, are also expected to be paid on a timely basis, and some debtors will use the line of credit to pay trade creditors who were not paid out as originally expected. If the value of inventory declines, or the accounts receivable are uncollectable, the borrowing base may be insufficient, and the outstanding balance may become over-extended.
If an unpaid balance exists at maturity, the creditor may extend the loan to be amortized over a reasonable period of time, demand repayment in full (i.e., refinance at another lender), require an infusion of capital into the business (if at all possible), or liquidate the collateral if it can be determined that the business is no longer viable.
Overdrafts include a pre-established line of credit used as overdraft protection to cover a check that would otherwise cause the checking account to be overdrawn. Creditors also provide overdraft protection with discretionary coverage of a customer’s overdrawn account for an overdraft fee; this fee is referred as an NSF fee, or non-sufficient fund fee. Creditors consider the NSF fee income as non-interest income, but such activity may not be encouraged as it may possibly set an unwarranted precedent. Such protection is actually an extension of unsecured credit to the account holder.
Lending personnel closely monitor overdraft activity, as it may indicate that the customer or debtor may be experiencing financial difficulties.
Participation Loans: Sold, Purchased
A loan participation is where the ownership of a loan is split between the originating lead institution and another lender, or groups of financial institutions and entities. For example, take a 50% transferred interest; this means that there has been a 50% participation sold (agent institution selling that portion), and a 50% participation purchase (purchasing bank). The lead institution will be the agent institution and manage the loan relationship for the benefit of the parties who hold a participation interest. The lead institution is responsible for maintaining and keeping possession of the documentation in its own name, servicing the loan with all reporting, payments, contacting the borrower, and the receiving of financial data, etc. The information is communicated to the other parties who own a portion of the loan.
Such participation purchases are done where the buying institution needs to acquire loans when loan demand is slow. When a borrowing relationship exceeds the lending limits of a creditor and becomes too large, and in order to maintain a relationship, the lead institution will sell an interest in the loan to another lender as well. In any event, the purchasing institution is responsible for doing its own due diligence underwriting for the deal as if they were originating the credit themselves. Such agreements are generally made on a non-recourse basis (can’t collect from the lead institution if the borrower defaults), even though the lead is responsible for servicing the loan.
Single Family Residential (SFR) Real Estate Loans
Residential lending for single family dwellings is long-term financing using the subject property as collateral. Underwriting includes an evaluation of the borrower’s ability to pay the mortgage payments, taxes, insurance, and all other loan obligations and home expenses in relation to his income. Private mortgage insurance may also be charged if the LTV structure is too high. The current market value of the collateral is usually based on an appraisal, or an ‘evaluation’ of the property if the loan transaction is less than $250,000.
Small Business Administration (SBA)
U.S. Small Business Administration (SBA) has lending guarantee programs for small business that are 50% to 85% guaranteed by the U.S. government in the event of default. Approved lenders are able to issue a variety of loans, including 7(a) loans (working capital loans), CDC/504 loans (owner-occupied commercial real estate loans), CAPLines (revolving lines of credit), export loans (exporters), microloans (small working capital loans), and COVID-19 relief loans (paycheck protection program loans, disaster loans). Absent the U.S. government guarantee, it is unlikely financial institutions would be able to lend to these debtors due to an insufficient down payment or collateral, low interest rate, longer repayment periods – SBA loans are not set up with conventional underwriting terms and conditions. The paper-work and technical requirements must be strictly adhered to in order for the SBA to stand behind its guarantee. It is typical to take at least 30-90 days to close some SBA loans.
SBA 7(a) loans – Commonly extended to start-ups and established businesses needing to expand, but with experienced business ownership with excellent credit. The purpose may include working capital, refinance existing debt, leasehold improvements, business purchase, real estate, or equipment. Terms range from 10 to 25 years, and rates are generally variable. As little as a 10% to 20% down payment is required.
SBA 504 loans – Made to finance the purchase, construction, renovation of owner-occupied commercial real estate (CRE), or purchase of fixed assets. The loans involve two lenders, a Certified Development Company (CDC) and a financial institution. The lender’s portion of the deal funds up to 50% of the loan, and the CDC lends up to 40%, and the debtor contributes just 10% - a 50/40/10 split. The debtor will need to occupy at least 51% of the CRE and the rest can be leased out. Repayment terms may extend up to 25 years.
Standby Letters of Credit
A standby letter of credit is generally unsecured and is the lender’s commitment to pay a certain amount to a beneficiary of one of the financial institution’s customers upon certain performance requirements. A beneficiary may need to ensure that the lender’s customer can deliver certain goods or services by a certain time, quality, etc., and will get from the lender’s customer a standby letter of credit. If the lender’s customer fails to deliver, payment will be paid from the standby letter of credit. Non-financial standby letters of credit are also issued as performance bonds to ensure payment for the completion of building or construction contracts in the event a contractor is unable to deliver on his contract.
Unsecured lending is based on the financial strength of the obligor, his strong credit history, character, earnings potential, and liquidity – the value of any collateral is not necessary or required. Certainly, the character or integrity of the debtor or owner guarantor will need to be paramount for unsecured lending. It is presumed that the debtor will be able to repay the unsecured loan on the prescribed terms and conditions, because if his financial condition deteriorates, credit risk, or the lack an ability to repay, increases. The creditor will require the debtor to maintain appropriate (i.e., current, accurate) financial information on file at all times to help ensure the prospect of repayment is maintained. This documentation may include financial statements, bank statements, tax returns, etc.
Creditors will expect an unsecured debtor to have adequate global cash flows as verified on its tax returns and bank statements. He must have the capacity to service all debts at a reasonable level. That capacity should show the ability to amortize the debt over just a few years, as well as cover living expenses and taxes. It’s likely there will be a limit as to a borrowing amount as a percentage of the debtor’s tangible net worth, say 20%. There may also be a ‘resting’ period of 30 days to clean-up a line of credit at a zero balance. Unsecured revolving lines of credit are granted to individuals and businesses.