Too many banks in the last financial crises fundamentally misunderstood or did not pay attention to structural subordination risk. We feel that this pattern is partially repeating at some banks today. Further, most banks overestimate the amount of credit support that can be recognized across corporate entities and individual sponsors, and this leads to misguided lending practices. We want to explain where banks can buttress their credit underwriting when dealing w
Tag: Credit Analysis
In banking, as everywhere else in life, you never get a second chance to make a first impression. The first page of a credit memo is essential for credit analysts, lenders, management, and board members. The first page is prime real estate where the average reader will spend 25% to 50% of the time reviewing the credit submission. Because the first page commands so much of the average reader’s time, it is vital to draft the first page clearly, concisely and compellingly.
The Credit Memo
With eclipse-mania in full force, we note that according to market professionals, commercial real estate has gone through an eclipse of its own and is now starting to wane. A survey released last week by JP Morgan of major real estate investors to include banks, insurance companies, pension managers, hedge funds, money managers and REITs shows that most investors believe we are in the late stages of the commercial real estate market expansion and that a more defensive posture is warranted.
The credit quality of a borrower moves in three dimensions. The obvious dimension is, of course, credit. However, a second dimension is credit volatility or how likely that credit is set to move over time. The third dimension is credit selection risk or the risk that your underwriting isn’t accurate. Selection risk can be thought of as underwriting error. Some industries and some borrowers are more complex than others, and the risk that your bank determines the loan as a low credit risk while it is high or vice versa can be quantified.
Most banks serve a geographical area largely defined by a political outline, such as a set of counties. Other banks choose less defined regions, such as the “Tri-city Area” or “Northern Virginia.” While these defined service areas may be fine for marketing purposes, when it comes to operating efficiency, banks may want to think along other dimensions of geography. In this article, we explore how banks can gain more efficiencies by allocating resources to areas other than political areas.
First, let’s stipulate that we really have no idea where we are in the real estate cycle. We recognize that this is less than stellar opening sentence and one that doesn’t inspire confidence, but we don’t want to mislead. That said, since we are forced for management and regulator purposes to monitor the real estate business cycle, we have a model that looks at each major commercial real estate sector and predicts where we are in the economic cycle. For ease of understanding, we have equated the real estate cycle with the proverbial baseball game.
We are currently considering an interesting loan opportunity for a community bank. The loan is an $11mm term credit to finance the construction and operation of a cold storage facility. The warehouse will be operated by a medium-sized regional company. Our bank was asked to participate in the credit, and our analyst took only a few hours to spread the numbers. All of the cash flow, liquidity, and leverage ratios were analyzed.
We recently worked with a bank that was competing for a loan relationship. This initial credit opportunity with this client was just over $4.5mm.
It used to be a banker at a major bank you would go through a credit training program where you would spend weeks learning to tear apart a set of borrower financial statements. We can tell you from experience that it was too much. Unfortunately, these days, the pendulum has swung the other way and with the advent of credit spreading software such as CreditQuest we have almost made it too simple. For young bankers coming up through the ranks, consistent training is hard to come by, and fewer bankers understand what is important and what is not in credit analysis.