By Nick Reynolds, Vice President/Credit Services Manager
The risks associated with business lending differ significantly from those associated with traditional consumer lending. While consumer information is still an important part of knowing your member, the types of risks associated with commercial loans tend to be more varied and wider in scope. This article is one in a series to help credit unions more clearly understand some of the unique risks of business lending.
Standard practice in commercial loan underwriting requires that both the borrower and all guarantors qualify for the credit. In some cases the borrower may not qualify for the loan and you must rely on the strength of one guarantor to approve the loan. The assumption that one strong individual can support a weak credit is the basis for a combined analysis of all related parties, better known as “global analysis”.
It is generally believed that this is a valid method of analyzing a loan request, but there are a few reasons to think twice. Foremost among these reasons is that the success rate of having a guarantor service a loan that has gone bad is generally quite low. Asset recovery experts will tell you that once a project fails, the typical guarantor will either have no assets left to service the loan, or will file bankruptcy to protect what they have left. Either way, your chance of collecting from a guarantor is minimal. One option is to make your guarantor a co-borrower, but this can actually be worse from the lender’s perspective because the individual waives some protections as a guarantor that are available to them as a co-borrower.
Despite these challenges, in practice you will need to use global analysis at times. One of the great benefits of being a credit union is that you know your member. If you know the business and its ownership, have worked with them for some time, and have a good feel for their integrity, you can avoid most of the problems associated with trying to collect from a guarantor.
Consider a couple of scenarios. One is an investment property that is not quite meeting an adequate debt service coverage ratio, but the borrower has a solid plan to increase rents to market rates over the next year. In this case, with a solid guarantor you can make a case for approval.
On the flip side, you have a borrower that has approached you for financing a large new project with highly uncertain outcomes, such as a new hotel. In this case, your guarantor had better be very strong, with the highest level of integrity. Most deals will fall somewhere between those two extremes, and your assessment of the guarantor strength should correlate closely to the riskiness of the request.
Timeframe is an important factor as well. For example, if you are financing a loan to purchase an underperforming property, and the principal has a solid business plan and the available capacity to support the project, it may be an approvable deal. Today. But it would be wise to set expectations with the guarantor about what happens if the deal does not perform as expected. What is the exit plan? Will you expect additional pay downs from other sources? What is the timing of those pay downs and will they be tied to a specific measure like debt service coverage ratio?
As a general rule, you should not be locked into an under-performing property forever. Any decision to lend on a property that does not cover its own debt service should be based on a reasonable expectation that the borrower will raise the property to an acceptable level of performance within a reasonable time. A strong guarantor is one that has both the capacity and the willingness to ensure the property performs as advertised. It is this assumption on which the validity of the global analysis method is based.
/by CU Business Group
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