After the C’s and P’s of credit, one of my favorites expressions from my banking career is that it is a “belt and suspenders” operation. I once attended a government-guaranteed lending conference at which a presenter literally wore belt and suspenders simultaneously. He either had an uncommon, subtle sense of humor for his trade, or he had completely internalized years of risk mitigation that naturally flowed into his wardrobe choices. One thing I knew was that those pants had no chance of dropping to the floor during his presentation.
Banks must be risk-averse. The money they lend is not their own. It belongs to depositors like you and me. At some point, we will want our money back. If we ask for our money and they don’t have it, the doors close. Anyone who has seen It’s a Wonderful Life knows what that looks like.
The rule of thumb is that banks must be right on credit 99.9% of the time. Right on the decision to lend. Supported by the right documentation, properly executed. Right servicing and monitoring to protect collateral and avoid gut-wrenching surprises like insurance lapses. Right collection efforts. Everything needs to be darn-near perfect.
Based on the bank’s history, experience, and the markets it serves, the bank establishes its own underwriting guidelines, documentation requirements and processes, loan monitoring processes, and collection and liquidation processes. In general, banks do a fine job in all these areas. During boom cycles banks can get entranced in the “Midas Myth” that every deal is solid gold and lose some rigor. Regulators and elevated credit losses typically slap them back to reality. In short, it probably takes “belt and suspenders” to operate at 99.9%.
The important thing to keep in mind as we assess incremental operational needs to support SBA lending programs is that the primary risk mitigant for banks is client selection. If banks have not selected clients with stalwart character and proven capacity to repay, there is no amount of credit documentation that can keep their performance at 99.9%. Don’t get me wrong. Banks are committed to appropriate documentation. Their conventional lending process is simply not as heavy on documentation and monitoring as the SBA.
Now, let me introduce you to the all-important “credit elsewhere” test to qualify for SBA loans, which essentially states that a bank cannot gain an SBA guaranty on a credit transaction if the borrower qualifies for credit on conventional terms. Without this provision, the most risk- averse banks might attempt to get an SBA guaranty on everything, limiting the reach of the program to borrowers who may need extended terms or lack sufficient collateral. I don’t know where that takes the “belt and suspenders” metaphor, maybe some Velcro to boot? The point is that SBA lending, by virtue of the “credit elsewhere” test, poses elevated risk to the conventional bank portfolio. Every aspect of the lending process requires intensified work.
If you talk to a seasoned SBA lender, you will be regaled by “war stories” of highly unusual requests and the lengths to which the lender went to fully underwrite and monitor to SBA standards. In the interest of time, I will try to summarize some of the additional work required to perform as an SBA lender.
First, the SBA’s SOP is an overlay to the bank’s own credit policy and procedures. As referenced in a previous blog, the 400 page SOP is rife with vagaries and inconsistencies. When a lender has a question about a “fit” for the program, it must navigate the SBA hierarchy to get a ruling on the question. Again, “credit elsewhere” almost guarantees that the lender will shepherd unique deals through the SBA channel, so always questions and clarifications.
Second, banks typically know their borrowers reasonably well from local market contacts and direct knowledge. A comfort level evolves over time that people are trustworthy or not, and the bank will rely on broad clearinghouse information such as credit reports to quantify that to the extent possible. Convincing people in Washington, DC that you know your borrower can be an entirely different matter. Given the genteel nature of most bank operatives, they are unaccustomed to asking questions like, “Have you ever in your adult life been dropped into the back of a police squad car? If so, what were the circumstances?” I recall one transaction in which we had a borrower explaining a “drunk and disorderly” from the 1960’s. He was 18 years old at the time. It is not unusual for SBA lenders to be in direct contact with courthouses across the country, seeking formal dismissal documents from cases decades ago.
Finally, credit underwriting standards and credit monitoring processes are typically much more strenuous, requiring additional manpower. The fact that SBA lending opens the door to 7 year terms on working capital loans means that the lender will have to stay current on asset valuations that are very fluid, particularly receivables and inventory. Conventional lenders would be very reluctant to extend long-term credit on short-term assets. Current assets like receivables and inventory can disappear overnight, never mind 7 years.
Before I say anything else, I want to stop for a moment to express my own gratitude to SBA lenders for the level of commitment they make to deploy capital to as many small businesses as possible on fair terms. It is not easy work.
With respect to PPP, all the traditional SBA requirements will likely apply. Lenders are left asking questions about what it will take to monitor this new portfolio of loans to the satisfaction of SBA. If a bank previously relied on real estate as a potential repayment source for the loan and knew how to get quality appraisals, surveys, flood certifications, etc., what are they going to be asked to do on behalf of SBA when the key considerations are payroll size, employment statistics, etc. Will the SBA trust the borrower, or ask banks to intercede to validate? To the best of my knowledge, the loan documents are not even available yet.
My take on the belt and suspenders…… Effective? Yes. Uncomfortable? Most likely.
NEXT TIME: The Economics of SBA Lending
