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•• - : - - - I . - ·- '\, ' r I ~ ,- ·•,... • !\ --- - . ._ "':- . r ln fRlityen . , . - ,... ,- I • ,_ •• - , ._,-I I J \ • - ' l f)• LI~ ~:, ;-; Y mo Federal Reserve Bank of Atlanta Volume 6, Number 4 Community Development Lending Requires a Structured Approach By definition, virtually every community development loan or investment activity will have a social mission, such as providing affordable housing for low- and moderate-income persons, revitalizing distressed commercial or residential areas, or providing loans to small businesses. Social work has become an integral part of the development ac tivity, and many new projects combine health care, day care, technical assis tance or education programs as part of the project requirements. Most experts would argue that without these programs, community development projects will never meet their full potential. However, by its very nature community development lending and investment activity is financial, not social. Indeed, without a sharp pencil and attention to the financing details, very few projects will make it off the ground or sustain themselves over the long run. While recognizing that the social aspects of community develop- ment activity are critical to a project's long-term success, this issue of Partners takes a look at the financial angle of community development activities. Beginning with information on how to make community development loans and investments, the newsletter also provides insight into why some loans are not made, and why other loans go bad. Hopefully, the discussion presented will encourage safe, sound and profitable community development lending. An Introduction to Doing the Undoable Deal The project almost works - but not quite. With just a few more dollars, a new business can get started or an existing one can expand, new housing can be built or older housing can be renovated. It may be a business owner who is looking for a way to make a deal work, or community lead ers looking for ways to provide new jobs, additional goods and services, or more affordable housing. The bottom line is, the dollars, the collateral, or the expertise are not quite there and oth er alternatives are needed to make the deal work. Winter 1996 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis This article offers a map for finding your way through the maze of those alternatives. A sampling of federal financial and technical enh ancements is included, but those programs - both public and private - will change as our communities change and our beliefs evolve regarding how to best balance individual and societal responsibilities. What is needed is a meth od to locate possibilities, not just a listing of currently available programs. A step-by-step guide begins on the next page. Federal Reserve Bank of Atlanta 2 Doing the Undoable Deal Tlie followi11g article is an excerpt fro111 a guide prepared by Or. Larry Meeker, vice preside11/ al the Federal Reserve Ba11k of Kansas City. In his article, Or. Meeker disrnsses the tools and tcc/111iques of co111111unity dcvclop111c11/ le11ding, whicli i11c/urlcs /lie effective use of gra nts and subsidies. II 111ay be /1clpf ul lo review the flow chart in our ce11/erfold b1fore rearli11g /lie article.. Community development lending is complex and evolutionary by its very nature. Gap financing that was formerly available through federal programs may instead be ava ilable through a state or local government, through nonprofit agencies, or privately hmded foundations . Or it may not be ava ilable at all; some projects that were doable in the past may not get done in the future. Othe r " undoable" dea ls will get done, however, by partners who have foLU1d creati ve new ways to make projects work. What w ill not change is the need for communi ty leaders, lenders, and development resource people to form partnerships and work together to improve their comm uni ties. Regional, sta te, and local programs, as well as those of priva te foundations and involved corporations can also be added to the map. As the appropriate role of government in community and economic development is reconsidered, enhan cement programs will ch an ge accordingly. The necessity of ana lyzing financing gaps in projects and finding alternatives for filling those ga ps, howcvc,~ will not change. Lenders arc facing increasing pressure to participate in community and economic development projects. Partners in Co1111111111ity https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Part of the pressure is in response to Commun ity Rein vestment Act (CRA) responsibilities. But the interest often goes beyond that. Like other communi ty members, lenders too are adversely affected by urban decay, economic disin vestment, and the lack of a d iversified economy. The problems are often easy to identify. The difficul ty is in finding widely acceptable solutions. A frequent s uggestion is to und e rtake more community and economic development projects. This is the question facing lenders: ls it good business? No Term for Marginal Projects The financial litera ture is replete with terms describing different types of financing - consumer finance, real esta te finance, and commercia l lending to name just a few. There is no term, however, that describes the financing of marginal projects and borrowers. Proposa ls with insufficient or uncertain cash flows, too little collatera l, or that pose excessive interest rate risk or overhead costs a rc simply not done. For most lenders, their obligations to protect depositors' funds and earn profi ts for shareholders preclude excessive risk taking and inadequate profit margins. Indeed, these tenets of lending a rc basic, and n11d Eco110111ic Develop111e11t lenders and thei r regu la tors pursue them vigorously. Agencies Providing Assistance Despite these perceived difficu lties, man y LUldoable deals may be doable beca use of their eligibili ty for financial a nd ma nagerial assis tance. Various government and philanthropic entities provide assistance to projects that aid economica lly d isadvantaged individuals and commLU1ities. 17,e basis for tha t assistance ranges from job creation and support for minority businesses to housing low-income indi viduals. Many of the federal agencies providing this assistance are well known - the Small Business Adminish·ation (SBA), Rural Development (RD), and the Department of H o usi ng and Urban Development (H UD). The s ta te a nd local government programs, along wi th the philanthropic programs, a re less fami lia r but are often as s upportive as the fed eral programs. The process of using these program enhancements to make undoable deals bankable is termed develop111e11/ fi11a11ce. Article Objectives This article has two objectives: (1) to examine the structuring of develCo 11ti1111cd 011 next page 3 Doing the Undoable Co11ti1111ed fro111 previous pnge opmen t finance dea ls, and (2) to address the problems associa ted with institutionalizing development finance lending. ln both cases, the prevalent issues are the sa me as in conven tion al le ndin g. Standard credit ana lysis principles g uide the s tructuring of indi vid ua l deals; overhead costs a nd interest rate risk considerations g uide the decision to institutionalize the activ ity. The Deve lopment Process Finance The starting point to w1dcrstanding development finance lending is not the alphabet/n umbers soup of government a nd philanthropic programs - CDBG, HUD, NHS, EDA, U SC, UDAG, GNMA, SBA, 221(d)(2), 235, 50-+, 312, and so forth. These programs are the caulking that fill the financial and managerial gaps in individual projects and mitigate the interna l costs and risks associated with development finance lending. They a re resources that ca n make deals work, but only after a thorough project analysis. The critical issues and decisions associated with development finance lending are easily Lmderstood when analyzed sequentially (sec chart on pages 6-7) . The upper portion of the chart, the project analysis, addresses credit issues associa ted wi th strncturing individual projects. The lower portion (high lighted in beige) addresses internal or organizational issues associa ted with development finan ce lending. ll1c project ana lysis section of the chart (upper portion) begins w ith credit anal ysis. Development finance projects are treated like any other project the lender considers and arc subject to the sa me underwriting criteria. Projects that initially pass the credit test without enhancements arc eligible for conventional fin anci ng. By definition, development finance projects will fail the test until enhancements are used . For projects that fai l the cred it Winter 1996 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis ana lysis, weaknesses or gaps are identified and matched with ap pmpriatc enhancemen ts. Si nce th e enhancements usua lly produce additional financial support, the project cash fl ows change. This change req uires another cred it analysis. Projects often cycle through this process several times to obta in the optimal combina tion of enhancements. It is a discovery process which the Hunga rian che mis t, A lbe rt con Sccnt-Gyorgyi, once described as "seei ng what everybody has seen and thinking what nobody has thought." If the project can be made creditworth y, however, there is no g uarantee it will be funded by a lender. Much depends on the lender's motivations and business constra ints. The following sec tions exp lo re the cred it and institu tional ana lyses individually. Credit Analysis Issues T11c credi t analysis part of the developmen t finance process foc uses on protecting the lender's fund s. Lenders, in contrast to equity investors, demand a high probability of re pay ment and use the credit ana lysis process to obtain that assurance. Projects that pass a variety of cred it tests arc fina nced; those tha t do not are not financed. Operating Expenses ancl Net Operating Income From expected cash flow, operating expenses must be met first. These expenses include the d aily costs of operations, utilities, and management; property taxes; insurance; ma intena nce and repairs; and a reserve fo r replacing capita l items. Deducting operating expenses from gross income lca\'es net operating income. Net operating income is the primary source of loa n repayment. A measure often used to eva luate thi s source is the debt coverage ratio (net operating income divided by debt service expense). Projects with a va lue greater than 1.0 ca n service debt from operations. Collateral If cash flo w fai ls to service debt, lenders seek a secondary source of repayment in the form of collateral typically the asset being fin anced. Loan to value ratios are a common colla tera l measure, comparing the value of the property to the loan against it. These ratios arc usua lly less tha n 80 percent and vary according to the nature of the collateral. Acceptable ra tios are lower w ith specia lized properties such as single-use manufacturing facilities and with properties in disadva ntaged locations. Whatever the property, the appropriate measure of its value is its market va lue, not the amount invested. In the case of many commLm ity development projects, collateral va lue is considerably less than the constructio n simp ly because of the property's location. Ownership Incentive Another factor lenders consider in eva luating a project is ownership incentive. Even if a project produces sufficient cash flow to serv ice debt, owne rs shou ld get a s ufficient return on their invesh11ent to ensure their continued interest. A common measure of ownership incentive is the cash flow ra te (cash flow di vided by the owner's investment). With many development finance projects, these rates a re far below the typical 15-20 percent minimums often required by in vestors. However, this deficiency need not pose pmblems. Equity investors in development finance projects arc often satisfied with other incentives such as tax benefits or even the fulfillment of commw1ity service objectives. Wh ile cred it decisions a rc la rgely financial in nature, other factors arc also important. Perhaps most important is the borrower's cha racter. An S1•c Ooins lite U11doah/c pa~e I I Federnl Resen 1e Bnnk 1f Atlnntn 4 Why Banks Don't Make Every Loan You Think They Should Make Tlie following article is excerpted fro111 a paper prepared by Ron Z i111111erman entitled, "Banking for Non bankers: Why Banks Don 't Make Every Loan Yo11 Tliin k They Should Make ". The paper, originally written in September 1989, was updated in December 1995 and presents a si111ple discus sion of important banking concepts that help explain why below 111arket rate loans and higher default rates are difficult for banks to absorb. For a copy of the paper in its entirety, please contact this Reserve Bank. The key to understand ing how banks work is in knowing that banking is a highl y leveraged, low margin, high volwne business and gaining an appreciation for the constraints that these characte ristics place on banks. In addition, to truly understand banking one must realize that banks are regulated entities and face keen competition from both with.in and outside the industry. Leverage When a bank loan officer lends money, he or she must be mindful tha t most of the money belongs not to the owners, but prima ril y to de positors. As a ru le of thumb, a bank in sound condition would be considered to be adequately capita li zed if its ca pita l a mo unted to abo ut 7 percent of the bank's tota l assets. This mea ns that for each dollar loa ned out, onl y 7 cents is the bank owners' money and the re mainin g 93 cents belongs to someone e lse. While federal deposit insurance has eliminated man y concerns, the high leve rage in banking continues to be both the boon and the ba ne of bank investors. On the o ne hand , leverage ca n mean that a seemingly insign ifi cant profit on the bank's assets ca n yield a nice return on the a mo unt the bank owner has invested. On the other hand, even a sma ll loss on the bank's asse ts can mea n a sizea ble loss to the bank stockh o lder. Partners in Comm unity https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis For insta nce, assume a one dollar loan . If on ly 7 cents of that dollar be longs to the bank investor, then even if the bank nets onJ y a 1 cent return on that dollar, the inves tor's retu rn is slightly in excess of 14.25 percent (i.e. $.01 di vided by $.07 times 100). By the sa me token, if the bank loses 1 cent of the dollar, the in vestor's loss is 14.25 perce nt. Note that depositors do no t share in the profits or losses because they do no t sha re in the risk of the investments. In effect the depositor has opted for the comparative safety of an insured but lower yieldi ng d eposit account rather than a n equity investment which brings the possibility of a higher re turn but a lso a grea ter risk of loss. Profitability Bankers use two primary measures of bank p rofi tability: return o n assets (ROA) and return on equi ty (ROE). ROA is net income divided by to tal bank asse ts ex pressed as percentage. ROE is ne t income di vided by total stockh olders' equity expressed as a percentage. ROA and RO E have different uses, but both are important. ROA is used to compare one bank with another. RO E allows analysts and investors to compare a bank's performance to not onl y other banks but to companies operating in other industries as well. One must rea lize that a bank's ROA and ROE has to be competitive in the marketplace. Otherwise, the bank and Econom ic Development cannot attract the investment capital it needs to grow. A bank is regarded as doing reasonably well if its ROA is 1 percent or better. In 1995, the average ROA for all banks in the U.S. was 1.3 percent. Large money center banks in particuJar wouJd be very pleased with a 1 percent rate of return, since competition is so keen among these banks and wi th other competitors in the nonbank financiaJ service industries. Low Margin One might reasonably ask why banks cannot make much more than 1 cent on each dollar of assets. The answer is beca use banking is a low margin business. Banks' costs greatly offset the gross yields received on their inveshnents. Earning and Noneaming Assets Bank assets may be di vided into two broad ca tegories: earning and noneaming. Ea rning assets for the most part consist of loans and securities. Nonearning assets mig ht include actual cash on hand, the bank building, othe r rea l esta te owned (which primari ly consists of properties acquired through foreclosure) and loans that are not being repaid . One would logically conclude that the higher the percentage of ea rning assets, the more income a bank might expect to generate. For this reason, banks monitor the relationship between earning assets and Co11ti1111ed on next 11nge 5 Why Banks Don't Make Every Loan Co11ti1111ed fro111 previous pnge nonearning assets very closely. Hence, the volwne of foreclosed properties is particularly critical since, not only are these assets not earning interest but the bank typically incurs costs to maintain and sometimes improve the property w1til it can be sold . 1n addition, the bank must pay interest on the deposits used to fW1d a foreclosed asset despite the fact that the bank is receiving no income. This i.s why one often hears bankers say they do not lend solely based on collateral value. Absent a borrower's reasonably reliable source of cash flow, a bank generally wi ll not make a loan no matter how much the collateral is worth in relation to the requested loan amoW1t. Competitive Earnings Pressure on If a bank were able to earn an average 8 percent on its assets and paid an average 4 percent for deposits, its net interest income would be 4 percent. et interest income (NII) i.s the difference between the interest earned by banks on their loans and other assets, and the interest paid by banks for the use of depositors' fW1ds. NII i.s the largest component of a bank's earnings. Other sources of revenue, ca lled noninterest income, includes earnings from bank services such as fees for safekeeping services and trust accoW1ts, and service charges on deposit accoW1ts. Overall, a bank averages about 1 cent in noninterest income for each dollar of assets on its books. In our examp le, if we add this amoW1t to the 4 cents in NII, the bank's earnings before expenses amoW1ts to abo ut a nickel on the dollar of assets. Out of this, the bank must pay for its losses on loans that are not repaid, and pay its overhead expenses and taxes. Overh ead A ban.k's overhead expenses typically include salaries and employee benefits, rent on the bank buildings, Winter 1996 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis furniture and equipment, data processing systems, marketing ex penses, insurance, federal assessment for deposit insurance, stationery, postage, telephone, etc. Because of the high volume of transactions banks complete, large staffs and correspondingly large amoW1ts of office space, equipment and supplies are needed. In addition, its "back office" func tions (e.g. bookkeeping, data processing, marketing, and the like) are not readily apparent to the public. However, these fw1etions along with the more obvious expenditures result in a large overhead expense relative to many other industries. A representative figure might be arOLmd 3 cents on ead1 dollar of assets, although inflation, salary competition to attract and retain good employees, and other fac tors are constantly straining overhead costs. If we subtract the 3 cents from our nickel above, we are left with 2 cents before taxes and loan losses. Overall, a bank will be doing reasonably well if it is netting about 1 cent on each dollar of assets after taxes. That concludes a simplified description of how banks make money and how much money they make. In reality, the process is enormously complex with little room for errors in judgment or faulty execution. The exa mple above used whole percentage points for illustration. In actuality, bankers measure success or failure in fractions of a percentage point, or so-called "basis points" (100 basis points equal 1 percent). A few basis points swing in cost or income can mean a lot of money to a bank. For this reason, bankers a re kn0vvn to have some of the "sharpest pencils" arow1d, fig uring their costs to the fraction of a pe1my. Losses What constitutes high risk in a credit decision is a matter of opi nion. However, perhaps it can be put into perspective by exan1ining in a general sense how much a bank can afford to lose on loans. Let's take our $1 in assets again, remembering that the bank has about 7 cents in capi tal and nets about 1 cent on the $1 in assets. Assume, for example, that earning assets average 75 percent of total assets or 75 cents in loans. If only 1 percent of our loans are lost, that's 75 percent of the 1 cent in net income the bank would have made. If the bank netted 1 percent on the remaining 74.25 cen ts in loans (75 cents minus .75 cen ts lost), the actua l "profit" would amoW1t to .7425 cents in interest (74.25 cents times .01) less .75 cents in loan losses or a net loss of .0075 cents. So losing 1 percent of loans in this example equates to an overall loss of .0075 cents. As a practical matter, a bank may be able to absorb more in loan losses, perhaps as much as 2 percent, before the bank sustains an overall loss. This is because some banks' cost structures allow them to net a higher amoun t of interest income and some generate more noninterest income. However, losses of 1 percent on would loans surely ha ve the s t ock hold ers how ling since the return on their investment would in any case be below norma l for the bank (if not negative). Of course, even 2 percent is not much of a margin for error. It should also be apparent from these calculations that a 10 percent loan loss would render the bank insolvent! This helps explain why the highly leveraged nature of bankin g compels bankers to be so conservative in their credit judgments. Conclusion I.n conclusion, it should be noted that the inherent nature of banking severely restricts how conventional See Why Ba11ks 0011 ' I Make Every Loa11 011 page 8 Federnl Reserve Bank of Atlanta • I n g th e Project Analysis Project/Loan Analysis D ea I Ud oa b I e I Enhancement Analysis *Sample Subsidy Providers Gap An alysis . .... .... ... ... ... ... .. .......... .... . ··········· ········ ......... .... ....................... ......... ... .... ... ......... ... . .... ..... ............. .. .. .... ...... ... ..... .. .... . Project Development Increase Revenue 11 Empo..,errner"t Zc:nes (EZ'. Enterprise vmmun1 ,es EC), His tor c.; f'reservation , Tax Credits ., Income Housing Credits 2 - Rent Supplements Cash Flow Sufficiency HOME, Section 8 , Rura l Housing ··········· ······ ••·· ····· ··•···· ··············· ···· 3 Reduce Expenses Tax Abatemenr;s 4- Int erest Rate Subsidies 5 En ha ncemeni; Benefits Equity ( ,rants) r.---------- -----,, L---------------.J , Proper Loan Siructunng New Cash Flow Projection Stabilize Cash Flows (New Proposa') Cash Flow Project Proposals • Viability Analysis LJ r 1, , 'f'' 1 Predictability Increase Lender Compensation Collateral Adequacy S rengthen Collateral Coverage Management Ability Provide Management Assistance f'roje..t 0- ,- P-• ---1 t' Ie 1------- Project/ Lender Match High Transaction Lender Analysis https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis nrer-na (' 11 -n,., a e t-----l.------l Reduce Transaction Costs Costs Shift Transaction Costs Gaps Enhancement Co nd iti ons 8 Technical As~istance ·················· ··· ····· ··· ····· ····· ········ ···· ·· ·· · ························ ··············································································· ····················· r.----------------, ,Staff Training/Specializati<m , L---------------.J r.---------- -----, L----- - ---------.J Reduce Transaction Costs , Established L ommun,ry Organi, , :consortia/CDCs ; F;nanc,ng Flexibility ..1,, .. ... .. ... .. .. . ... .. .. . .. ...... .... ..... . ,-,.,! ... .... . 'nterest Rate Riss Manage nterest Rate Risk Enhancement Conditions " See following page r l f't ' lt',, 8 The ABCs of Subsidy Providers Low-income Housing Tax Credit (LIHTC) - a dollar for dollar tax credit that reduces federal income tax liability for investors in low- to moderateincome rental housing developments. HOME Program (HOME) - a federal grant program provided to local governments for the development of affordable housing; usually leveraged w ith private funding sources. Section 8 - a federal rent supplement program for low-income renters that pays the property owner the difference between the amount the tenant pays for rent and the market or contract amount. Rural Housing Loans - direct loans, guaranteed loans, and cred it towards interest ra te buy-downs ava ilable th rough the U.S. Department of Agriculture's Rural Development program for housing in rural areas. rhe list of sub;idy providers Jnd ovailable xograms Jrovided is a ;mall samJling of some )f the options ram which :ommunity fevelopment enders may :hoose. It is ntended to >e represen~tive - neither in exhaustive ·st nor an •ndorsement ,f particular •nhancement •roviders. \ny excluions are 1erely due to :,ace considrations. Enterprise Communities(EC)/ Empowerment Zones (EZ) - federal grant programs administered through the Department of Housing and Urban Development. Community Development Block Grants (CDBG) - grants alloca ted to state (non-entitlement) and local (entitlement) jurisdictions to engage in a variety of community development activities. Affordable Housing Program (AHP) - a Federal Home Loan Bank program that provides grants or loans to its member institu tions, which then make the fw1ds ava ilable to grantees or borrowers for housing development activity. Community Investment Program (CIP) - a Federal Home Loan Bank program that provides advance funds to its member banks who in tum provide maturity-linked, subsidized loan assistance for a variety of housing and small business development activities. Community Development Financial Institution (CDFI) - a financia l institution established with the sole pur- pose of promoting community and economic development. Bureau of Indian Affairs (BIA) provides management, technica l assistance, and loan guarantees for housing developments owned or occupied by Native Americans on trust land or in Indian or Alaska Native areas. Historic Preservation Tax Credits - a program administered by the U.S. Department of the Interior that provides tax credits for rehabilitation of hjstoric structures to property owners and long-term lessees. Veterans Administration(VA)/ Federal Housing Administration (FHA) - insures loans made by priva te lenders that make lower in terest rate or more favorab le term loans to borrowers. Small Busi ness Administration (SBA) -offers a variety of special loan and guarantee programs for small business start-up and expa nsion efforts. Local Initiatives Support Corporation (LISC) - a large, national, non-profit community development finance intermediary that also adnunisters LIMAC, a secondary market provider that invests in loans made by USC non-profit affiliates. Neighborhood Reinves tment Corporation (NRC) - a federa lly d1artered community development finance and ted1nical assistance intermed iary that works with non-profit community development organizations through its NeighborWorks network. NRC also operates a secondary market provider, NHSA, that invests in home mortgages made by NeighborWorks affiliates. Federal Home Loan Mortgage Corporation (Freddie Mac) - secondary market provider that purchases mortgages and resells them in the form of guaranteed mortgage securities. Federal Agricultural Mortgage Corporation (Farmer Mac) - pro- Partners in Community and Economic Development https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis vides a secondary market for agricultural rea l estate and rural housing loans by allowing the loans to be packaged and sold into loan pools that serve as collatera l for investors. Federal ational Mortgage Association (FannieMae/FNMA) - a publicly owned secondary market provider that is chartered by Congress to invest in home mortgages originated by private lending institutions. Government National Mortgage Association (GinnieMae/GNMA) provides a secondary market for private lenders by purchasing mortgages generated by subsidized programs to support the construction and purchase of low- to modera teincome housing. ♦ Why Banks Don't Make Every Loan Continued from page 5 banking products, in the absence of public or private enhancements, can be modified to make them mo re affordable for low- and moderateincome people. The fundamentals cannot be altered long term wi thout w1dermining the competitiveness of the banking industry and seriously jeopardizing banks' safety and soundness. There is a limit to the concessions that banks alone can make. That !imjt is far below the level needed to make long-term progress in addressing the needs of low- and moderate-income people. If one falls to recognize this fac t, one will be forever trying to pound a square peg into a round hole. Fortuna tely, there is better way: the pub li c/private partnership. Government, charities, and private corporations can wo rk with the banks to leverage their funds in ways that are affordab le and effective. In this way, each party can play to its strengths and through enlightened self interest, everyone involved can "win" • 9 Why Loans Go Bad by John Campbell Conventional Joans don 't always perform as agreed. In this article, a senior bank examiner reviews some of the reasons loans go bad, and offers several suggestions to prevent problems before they arise. Why do some loans, o riginated as apparently sound credits, d e teriora te as they age? O ve r the yea rs, I have hea rd lite rally hundred s of "wh y's". Often a loan offi cer w ho o rigina tes a loan tha t ends up on a bank's w atch list, on a delinquency report, or in the w orkout d epa rtmen t, points to exte rnal fac to rs o uts ide his or he r control. Problem credits are frequently attributed to a personal traged y experienced by the borrower, an unp redictable reversal in a borrow er 's financia l condition, fraud or misrepresenta tions by borrowe rs, borrowers tha t become uncoope rati ve afte r the loan is made, a downturn in the local or na tional econom y, na tural disasters, and o ther even ts that some lend ers feel w ere not fo reseeab le o r controllable. I think there is a more basic reason for loans going bad than the various "why's" discussed above. Although many unexpected events contribute to loans going bad, most loan problems that I have seen resulted primarily because lenders d id not closely adhere to fundam ental underw riting practices. Lenders need to anticipate a w ide range of possibilities. Adhering to time honored lending practices will protect the organization w hen the unexpected occurs. Lenders who do not closely evaluate a customer 's ability to repay in various scenarios - including ad verse circums tances - and structure loan s accordingly, often find the obligations they have booked end up in the charge-off records. Underwriting Win ter 1996 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis should include consideration of the "what if's" and provide fo r repayment if things don't go as anticipated. A type of loan that I have routinely seen in South Florida, the undeveloped land loan, often provides an example of faulty underwriting. All too often a lender violates fundamental underwriting rules when he or she makes a vacant land loan. In most cases, the repayment of these loans is dependent on resale of the collateral property and typically there are no other relia ble backup repayment sources. Generally borrow ings made on the undeveloped land a re to borrowers w ith limited cash flow to service the obliga tion. If the borrower does not or caimot sell the property in a relatively short period of time, the lender is often faced w ith deciding between either foreclosing on the property or deferring payments for extended periods. Underwriting standards are sometimes sacrificed because of ma rket competition. In rare cases, it is appropriate fo r a bank or other lending organization to approve loans that are exceptions tQ standard guidelines. However, the pressure to compete often drives an organiza tion to approve too many loans that do not conform to the institution's or industry lend ing guidelines. The current banking and general business environments seem to be stimulating growth initiatives and strong competition in a saturated market. Those influences may negatively affect adherence to pmdent lending standards. O ne loan offi cer I recently sp oke to alluded to pressure on lending standards. H e refe rred to the "hope fac tor" as o ne significant d e te rrent to sound un d erw riting. A lend er, he explained , often hopes a ma rginal loan presented for app rova l a t an ins titution w ill improve based on some future event. Loan com mittees may a lso overlook shortcomings in a loa n presenta tio n and approve a loan beca use of promises a bo rrower has made, other unrea lized expecta tions, and the compe titive push to book loans. A borrow ing ap p lica nt, for exa m ple, ma y indica te tha t even tho ugh the histo rica l cash flow fro m a n income p roducing p roperty being pled ged as colla te ra l does not provide adequate debt service coverage, a new lease being negotia ted will provide the necessary coverage. O r a bo rrow ing entity m ay p rov ide very positive earnings p rojections d espite losses in prev ious yea rs. ln o rder to ma ke a d ea l wo rk, the lende r a nd committee may be tempted to stre tch loan to va lu e g uid elines w ith o ut th o ro ughly assessing anticipa ted cash flows or fa il to closely evaluate projections. Excerpts from the Robert Morris Associates aimual fa ll con fe rence held October 20-22, 1996, and comments of local lenders evidence a general industry concern that nationw ide lending standa rd s may be under stress. The principal concern Co11ti1111ed 011 next pnge Federal Reserve Bank of A tlanta 10 Why Loans Go Bad Co11ti1111cdfro111 previous page expressed was that there is extremely heavy competition among lending institutions that is putting pressure on underwriting standards. In his keynote address at the RMA conference, David A. Daberko, Chairman and Chief Executive Officer, ational City Corporation, Cleveland, Ohio, sa id " ... the most compelling issue in corporate banking today can be put very simply: There arc too many dollars chas ing too few deals, creating an undesirable underwriting environment." He noted that " ... the signs arc there to be read by all of us: s lowing asset growth, narrowing margins, more lenient terms." The current strong business cycle has lasted longer than many have expected. ll1c stock markets are at record highs, retail sales remain strong, and corporate profits arc generally solid. Some economists feel that economic growth will continue unabated for severa l more years. However, some ana lysts feel that with increasing numbers of personal bankruptcies and increased levels of consumer debt delinquencies, an economic downturn may not be far off. Lenders who do not factor the possibility of a weakening general economy into loan decisions and who fai l to maintain tight underwriting standards, may be booking loans today that will be tomorrow's problems. Underwriting Sta nda rds Questions to consider arc : dent parties for real estate collateral. • Does the analysis contain appropriate financial ratios, trends, and cash flow history and projections to determine the fina ncing needs and repayment capacity of the borrower? • Lien and litigation searches need to be performed. • Are important items like sa laries, fees, dividends, notes receivable and payable to insiders eva luated ? • For receivable financing, current agings s hould be revi ewed for trends, concentra tions, ineligible accounts, and compliance with any borrowing base formula . • Inventory co lla teral schedules should be received and reviewed on a regular basis and adjustments made for obsolete or ineligible items. • Listings of equipment held as collateral should also be routinely evaluated considering "in place", "orderly liquidation" and "fire sale" values. • Routine visits to the borrower's place of business should be made to determine the condition of business operations, and the existence and condition of tangible collatera l. Jol,11 Ca111pbcll is a sc11ior exa111i11cr with Ilic Mia111i Bm11cl, of /lie Fer/cm/ Rcscr<1e Ba11k of Atla11/a. • /\re signifi cant balance sheet and income sta tement changes properly explai ned and arc financial statement footnotes reviewed? • Does the lender properly identify and review contingent liabilities? • Is the quality of financial information subm itted by the borrower commens urate with the size and complexity of the loan? Sound loan underwriting standards should ensure that a thorough anal ysis of loan purpose, repayment source, and colla teral are being performed. Analysis of financial information, projections, and cash flow~ arc critica l for maintaining credit quality. Loan structure, terms, and covenants must be consistent with the above analysis. The borrowing history and background of the borrowc1~ and industry and economic outlooks, genera ll y need to be reviewed in detail as well. • The va lue of sign ifican t col la teral should be assessed by independent parties and reviewed for reasonableness by in-house staff. The size and complexity of debt dictates the extent of financial ana lysis. • An environmental assessment also should be performed by indepcn- • Is the funds flow statement (source and use of funds) eva luated? The following controls shou ld be in place to ensure that the lending organization initially and routinely thereafter verifies the existence of, inspects the condition of, determines the value of, and perfects its interest in the collateral: Pnrt11crs i11 Co1111111111ity n11d Eco110111ic Dcvclop111('//f https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis • Frequent repricing of liquid and readily marketable collateral should be undertaken to ensure that proper margi ns arc maintained. • Intangible assets hould be eva luated using discounted current va lue of cash flows, multiples of net income, commissions or sales, recent market sa les or franchise va lues. • On-going reviews of comp liance with loan agreement covenants should be conducted and even ts of no n-co mp li an ce tra cked un til cured or waived. ndcrwriting should provide a clear understanding of the lender 's and borrower's responsibilities under the borrowing arrangement. All pertinent details relating to the loan sho uld be documented in writing, including secondary and te rti ary repayment sources, require ments for borrower's s ubmission of financial informa tion, detailed coll a teral descriptions, and default provisions. While a ll good lenders take risk, and sometimes the best laid plans go wrong, a11 01111cc of prn 1e11tio11, as the saying goes, is worth a po1111rf of c11rc. • I I Doing the Undoable Co11ti1111cd fro111 page 3 honest, committed borrower with the knowledge and experience to succeed wi th a project is essential. Also, knowledge of the commmtity and the loca l economy is essential to making smmd lending decisions. If a project involves the leasing of commercial space, the creditworthiness of the lessors is also important. Factors such as these must be considered and may be ca use for denial. If the project passes the credit tests, it can be funded with conventional resources. If it fails, however, a decision must be made about pursuing credit enhancements. This decision will depend on the project's eligibility for credit assistance and the willingness of the project sponsor to expend the effort to undertake further ana lysis. Asswning the decision is to proceed w ith fmther analysis, the nex t task is to identi fy project gaps and enhancements. Gap and Enhancement Analysis Lenders and investors have nun1ero us reasons for not funding projects such as wea k sa les projections, high overhead, inadequa te management experience, insufficient collatera l, and newness of a business. These deficiencies ca n be broadly classified as re turn, risk, and management gaps. Each rep resents a sound basis for not supporting a project. Marginal Debt Coverage Low return is perhaps the most common project deficiency. Simply stated, income does not exceed operating expenses by a wide enough margin to justify either debt or equity funding. l11e debt coverage and cash flow ratios may be too low. A variety of enhancements are avai lable to augment return by increasing project income or lowerin g expenses. Today, income sup plements fall into two basic categories - rent subsidies Winter 1996 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis and tax credi ts. l11e Section 8 housing certificate and voucher programs ad ministered by the U.S. Depa rtment of Housing and Urban Development are the nation's rent subsidy programs. Under these programs, HUD helps low-income households obtain adeq uate housing by issui ng certificates or vouchers for the difference between the cost of adeq uate housing in the market area and the renter's ability to pay. These payments thus enhan ce the landlord's revenues. Unlike rent subsidies that enhance operating revenues, tax credits do not alter a project's fin ancia l statements. However, they are integral to the fina ncial analysis of a project because they prod uce important returns to investors that emulate project income supplements. At the federal level, for example, ta x credits exist for low-income housing and the preservation of historic buildings. Both allow investors to obtain federa l tax credits for contributions of goods, serv ices, and cash to approved organiza tions, inc luding venture capital funds. Expense Reduction M easures A wide range of programs are available for reducing expenses. Local governments often use real estate ta x aba tements to red uce operating expenses and a ugment cash flow available fo r debt service and equi ty holders. Tax increment financing is another form of tax abatement that uses taxes for property improvements. Interest rate subsid ies can be provided in the form of below market rate fLU1ds provided by loca l bond issues. A direct ra te buydown in which a third party helps make interest payments is another fo rm of subs idy. Compensa ting balances and blended rate financing can also serve to subsidize interest payments. Equi ty g ra nts, in the form of property or cash may be avai lable to red uce expenses by loweri ng the amoLU1t of debt that will be requi red. Corporate and foundation grants to project sponsors are also popular, as arc invesh11ents by na tiona l and loca l community development organizations. Communi ty Development Corporations ( D s) are equi ty investment veh icles for na tio na l banks, state member banks, and for bank holding companies. A conventiona l technique often used to lessen the deb t service burden is to extend d ebt maturities. A final means of reducing operating expenses is the use of small business incubators. Incubators allow small businesses to share common facilities and office personnel and man y incubator tenants can access technica l expertise from nearby colleges. Risk Gaps Cash fl ow, collateral and management also present potential risk ga ps. Cash fl ow risk can be mitigated by stabili zing income and expenses through the va rio us s ubs idies. Collateral risk ca n be offset th rough the use of loan guarantees or equity financing, for exa mple. Management depth and expertise is a fina l projectrela ted concern. Two significa nt resources are incubato rs and management consultants. All of the enhancements bring constraints along w ith subsidies. l11ese cons traints may include job creation requirements or housing disadvantaged people. All the constrain ts must be satisfied . Successful completion of the cred it analysis process does not g ua rantee project financing. l11e lower portion of the chart depicts the institutional issues that must be addressed before the funding decision is made. However, a well-packaged d eal taken to the appropria te financial institution ca n become "doable". • f or a f ull rcpri11I of flll' guide, Doing the Und oa ble Dea l, Jllcnse co11tact the federal l!escn>e Bank of /\tln11tn. Federal Reserve Bank of Atln11tn , FEBRUARY JANUARY American Bankers Association, January 2225. Security Sales Management Foru m, Pa lm Beach, FL. Contact: (800) 338-0626 Information provided on upcoming events ofo~erorganizations should be viewed as strictly informational and not as an endorsement of ~eir activities. The National Council for Urban Economic Deve lopme nt, January 23 -25 . Redevelopment Finance, Tempe, AZ . Contact: (202 ) 223 -4735 Neighborhood Reinvestment Corporation, Feb ruar y 17-21. N eig hborhood Reinves tment Training Institute, Atlanta , GA. Contact : (800) 438-5547 Conference and Super Marketp la ce, Tucson, AZ. Co ntact: (800 ) 338-0626 Amercian Ban kers A ssociation, January 2629 . National Security, Audit and Risk Man ageme nt Co nfe rence, A tl anta, G A . Contact: (800) 338-0626 Amercian Bankers Association, March 2-5. Na ti ona l Fiduci ar y and Securities Operations Confe rence (NFSOC), Orlando, FL. Contact: (800 ) 338-0626 A mercia n Bankers Associa tion, February 2 326. ABA/ BMA National Conference fo r Co mmun ity Ba nke rs, Orlando, FL. Contact: (800 ) 338-0626 A mercian Bankers Association, January 2629. AC B/A BA N ational Mortg age Markets l NIARCH The Natio nal Coun cil for Urban Econo mic Development, February 24-26. Introduction to Economic Develo pment, W ashi ngton, DC. Contact: (202) 223-4735 The N a tional Cou ncil for Urban Economic Development, Februa ry 26-2 8. Fina nc ing Economic Development and Attracti ng Jo bs, W ashington, DC. Contact : (202 ) 223-4735 V ICE PR ESIDENT Ron Zimme rm a n ED ITOR Cou rt ney Dufries ASSOCIATE EDITOR M a rie Easley Free subscriptio n c-111d addiuonal copies are ava ila ble- upon rcqucs 1 10 Cornmunit y A lfai rs. Federal r~eservc- Bank o f A1larna. ICU Marie ll a S r.. N. \V. . All<mta . Georgia A mercian Bankers Association, January 2629 . National Trust and Private Banking Conference, W ashington, DC. Contact: 30303-2 71 3. (8 00) 338-062 6 Reserve System . rvlaterial may be repri111 ed o r abstrac ted p rovided tha t Punner.s is creclited and provided \-Vith a copy of ril e puhlica tion . or ca ll 404/5 89-7307 : F/\X 404-/589-7342 . The v iews l'Xpresscd are not ll l' CCSS(Hi l y l h OSl' of th e Fe dera l Rese rv e Bank of A tlan ra or the Federal Printed on recycled paper Com munit y A ffa irs Fe d e ra l Reserve Bank o f A tlan ta I 04 Ma rie tt a Street. NW A tla n ta , Georg ia 3 0 303-2 7 13 Pa rtners in Community https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis and Economic Development • I .