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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
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




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
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
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


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


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,
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.
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
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
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
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.


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
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


Why Banks

Don't Make
Every Loan
You Think

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 and outside the industry.

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
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.

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


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.



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
Federal Reserve Bank of St. Louis

furniture and equipment, data processing systems, marketing ex penses, insurance, federal assessment for
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.

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
However, losses
of 1 percent on
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
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.

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


page 8

Federnl Reserve Bank of Atlanta



n g

th e

Project Analysis
Project/Loan Analysis

D ea I

Ud oa b I e


Enhancement Analysis

*Sample Subsidy Providers

Gap An alysis

. .... .... ... ... ... ... .. .......... .... . ··········· ········ ......... .... ....................... ......... ... .... ... ......... ... . .... ..... ............. .. .. .... ...... ... ..... .. .... .


Increase Revenue


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

HOME, Section 8 , Rura l Housing

··········· ······ ••·· ····· ··•···· ··············· ····
Reduce Expenses

Tax Abatemenr;s

4- Int erest Rate Subsidies

En ha ncemeni;

Equity ( ,rants)

r.---------- -----,,

, Proper Loan Siructunng

New Cash Flow

Stabilize Cash Flows

(New Proposa')

Cash Flow
Proposals •


LJ r 1,

, 'f'' 1


Increase Lender


S rengthen
Collateral Coverage


Provide Management

0- ,- P-• ---1

t' Ie 1-------

Project/ Lender

Federal Reserve Bank of St. Louis


(' 11

-n,., a e t-----l.------l

Transaction Costs

Transaction Costs


Co nd iti ons


Technical As~istance

··· ····· ··· ····· ····· ········ ···· ·· ·· · ························ ··············································································· ·····················
,Staff Training/Specializati<m



r.---------- -----,
L----- - ---------.J

Reduce Transaction

, Established L ommun,ry Organi, ,


F;nanc,ng Flexibility

..1,, .. ... .. ... .. .. . ... .. .. . .. ...... .... ..... . ,-,.,! ... .... .

'nterest Rate

Manage nterest
Rate Risk


" See following page

r l

f't ' lt',,


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
Jrovided is a
;mall samJling of some
)f the options
ram which
enders may
:hoose. It is
ntended to
>e represen~tive - neither
in exhaustive
·st nor an
,f particular
\ny excluions are
1erely due to
:,ace considrations.

Enterprise Communities(EC)/
Empowerment Zones (EZ) - federal
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
Small Busi ness Administration
(SBA) -offers a variety of special loan
and guarantee programs for small
business start-up and expa nsion
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.
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
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.
Association (FannieMae/FNMA) - a
publicly owned secondary market
provider that is chartered by
Congress to invest in home mortgages originated by private lending
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" •


Why Loans Go Bad
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
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


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
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
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
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
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


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,
23 -25 .
Redevelopment Finance, Tempe, AZ .
Contact: (202 ) 223 -4735

Neighborhood Reinvestment Corporation,
Feb ruar y
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
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.


(800 ) 338-0626
A mercian Bankers Association, January 2629. AC B/A BA N ational Mortg age Markets



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

Ron Zimme rm a n
Cou rt ney Dufries
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.

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 .


ca ll

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