Easily quantifiable risk vs. using a crystal ball
You’ve probably heard about “Stress Tests,” the exercises that the mega-banks go through to demonstrate to their regulators that they’d be viable in the event of another meltdown. These efforts are complex and the formulas on which they’re based, extremely sophisticated. Their worth is still to be determined. Remember that there were equally esoteric studies done at the turn of the century to demonstrate that sub-prime mortgages were a secure investment.
Stress testing is really just downside risk analysis, i.e., looking at what might go wrong. Lenders do it with every loan they make. You do it when you lend your brother-in-law $500 for air fare to Fargo to look for a job. You’ve carefully analyzed the cost/benefit relationship and you’ve determined that your money’s most likely gone, but so is Bubba.
Before 2008, many banks performed only a perfunctory downside risk analysis. There were a lot of banks competing for business, and the pressure to book interest and fee income was intense. Truly assessing the risk, and taking into consideration what really could go wrong, generally meant that you didn’t get the business.
The kind of lending that a bank engages in can make a difference. Some lenders specialize in a market segment that makes risk much easier to quantify; others may have to use a very cloudy crystal ball.
The following tale of two banks illustrates this dichotomy:
Cue up the music and we’ll step back to the summer of 2007. Let’s call one bank Great Eastern Mega Bank, and the other, a bank specializing in agricultural lending (ag bank), Second Bank of the Plains.
Great Eastern gets a loan request to make a speculative construction loan on, say, a 41-unit commercial condo complex in another state. The economy is hot, the real estate market hotter, even though the storm clouds heralding an F-5 financial storm are on the horizon. GEMB gets an MAI appraisal on the proposed project, determines that the current market value of the complex, were it completed at that time, is a healthy number and well above the cost to build.
Recent absorption rates for commercial real estate are analyzed. Then an assumption is made that the rate will deteriorate by a certain percentage.
Historic and current rental rates are reviewed and also scaled down.
Finally the income and liquidity of the borrower, probably a professional builder-developer, are viewed. Both are healthy; tax returns show an impressive net income, there’s a lot of cash in the bank. But all of that income, all of that cash, was derived from selling developed property in a strong market.
Great Eastern may have thought it adequately assessed downside risk, but the whole process was based on recent history. If just one element of the profile, absorption rate, market lease figures, projected sales prices or borrower income went south, it meant that the whole structure was no longer viable.
Focus now on Second Bank of the Plains, and how it looked at risk in its portfolio. Farmers are protected by revenue guarantee insurance for crops like corn and wheat. SBP based its operating loans not on the current price of the commodities, which might have been relatively high, but on the lowest per bushel revenue the borrower could get, i.e. the amount that would be paid by the insurance.
Second Bank would make loans on agricultural land, but kept the amount conservative, maybe at 50 percent of value, and selling any loan above that level into the secondary market.
Also, the bank determined the unit production cost of, say, corn or wheat, and then calculated the debt service factor on a decline in the commodity price of 20-25 percent. If the farmer could weather a significant drop in the price of the crop, the loan might have been a good one.
Admittedly, ag banks have a significant advantage in that their loans are based on the prices of a vital commodity: food. There will always be a market price, and a comparable drop in the price of wheat to the 2008-2010 decline in real estate values is practically impossible. And Second Bank would have spread its risk, because crop prices are very rarely uniformly up or down. When corn is up, wheat might be down. When hay is low, sugar beets may be high.
Still, did Second Farm make mistakes along way? Absolutely, at some point. In lending money, it’s impossible to be right all the time. Bubba may get lucky in a poker game and be back on your doorstep in a week.
If Great Eastern were to make the same loan today, they would approach it differently. Possibly they might take some of that borrower liquidity and put it into an account pledged against the loan as additional collateral. They would certainly make certain that the borrower had a strong prospect of sufficient income to service the debt if the project didn’t sell or lease.
One of the oldest mantras in banking is, “We might make a bad loan, but we try not to make a loan badly.”
Pat Dalrymple is a valley native. He’s been in the mortgage and banking business since 1961. He’ll be happy to answer your questions or hear your comments. His e-mail is firstname.lastname@example.org.
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For the last decade Ken Murphy kept building on his plans for a River Outfitting store.